Vanguard Warns of Worsening Odds for the Economy and Markets

The chances of a recession by the end of 2020 are mounting. And the prospects for the American stock market in the next decade have worsened appreciably.

Those are prognoses, not facts. But they’re not just offhand projections, either. They are the sober assessments of Vanguard, the $5 trillion asset management firm. And they suggest that the current good times may amount to a reprieve: an opportunity to make sure that you are prepared for a storm.

Vanguard, known for its caution, emphasizes that this is a general forecast. “We don’t make any actual predictions about where things are going next month or, in the markets, next year,” Greg Davis, the company’s chief investment officer, told me. “The stock market could rise a lot, short-term. We don’t know.”

The United States economy could well turn in another series of strong quarters, with the annualized growth rate of gross domestic product above 4 percent, and the unemployment rate below it. Those are statistics for the second quarter, and just may be surpassed over the next year.

But in the Vanguard view, the odds have increased sharply that more challenging times are coming. It is likely, Vanguard says, that the long stretches of sizzling stock markets since 2009 — bouts that have made investing a winner’s game for those lucky enough to afford a seat at the table — will become much rarer.

Vanguard tracks data to predict the likelihood of a recession at certain points in the future. In recent years, the company has put the probability of a recession six months out at close to 10 percent. Now, Vanguard says the chances of one by late 2020 are between 30 and 40 percent. That’s Vanguard’s highest-ever estimate for that time frame, Mr. Davis said. (A six-month forecast reported a greater than 40 percent probability before the recession that started in December 2007.)

The recession projection is based largely on interest rate expectations using two criteria, according to Freddy Martino, a Vanguard spokesman. One is what economists refer to as a flattening yield curve, with the Federal Reserve expected to raise shorter-term rates faster than longer-term ones. The other is rising credit risk for below-investment-grade bonds.

If the facts change — with, say, the Federal Reserve delaying anticipated interest-rate hikes in response to a weaker economy — the recession forecast will change, too, Mr. Davis said. To be clear, Vanguard isn’t predicting a recession; it is merely saying that the odds of one have risen.

“You could also say the chance of a recession not occurring by the end of 2020 are 60 to 70 percent,” said Fran Kinniry, a principal in Vanguard’s investment strategy group. “You want to be prepared for a downturn,” he said, without becoming so risk-averse that you fail to benefit if investments rise.

The forecast suggests opportunities, not just problems, Mr. Davis said. The 10-year outlook, for example, includes lower projected annualized returns, but still positive ones, for these two stock categories:

■ United States stocks, an expected 10-year return of 3.9 percent, annualized, down from a projection of an 8 percent annualized return, made in March 2013;

■ Stocks from markets outside the United States, 6.5 percent, annualized, down from 8.7 percent in 2013.

Non-United States stocks are more attractive for equity investors, on a relative basis, than they were five years ago. (That is partly a reflection of the out-performance of domestic stocks, making them far pricier than they were before.) What’s more, Vanguard projects improved 10-year annualized returns for these asset classes:

■ A diversified portfolio of United States bonds, 3.3 percent, annualized, up from 1.7 percent in March 2013;

■ Bonds from outside the United States, 2.9 percent, up from 1.8 percent;

■ Commodities, 5.9 percent, up from 4.2 percent;

■ United States Treasury bonds, 3 percent, up from 1.3 percent;

■ And cash, held in United States money market funds, savings accounts or other instruments, 2.9 percent, up from 1.5 percent. Short-term cash is becoming more attractive — with greater liquidity and, often, lower risk — compared with holding bonds.

Experienced investors who are “sophisticated enough to focus on these numbers and act on them themselves” can benefit by making their own adjustments, Mr. Davis said. Tried-and true investments like balanced funds and target date funds (which become more conservative as a given date nears) can make basic adjustments for you. Advisers can do this as well.

Tweaking investments can make it easier to live with them — and not panic — if markets fall, Mr. Kinniry said. At the moment, though, many Americans appear to be setting themselves up for trouble.

By the start of this year, the stock portion of investment portfolios swelled to 63 percent, the highest level in decades, according to a Vanguard analysis. That reflects the rising value of stocks after one of the greatest bull markets in history.

American portfolios had the same high proportion of stocks in September 2007. People bailed out as the market crashed a decade ago — taking huge losses after prices had already fallen — and reducing the equity proportion of their portfolios to only 38 percent in January 2009.

Yet in March 2009, stocks began rising. It would have been better to have held more stocks in early 2009, and to have reduced them when stock prices were high, as they are now. “You don’t want to panic and sell after the market falls,” Mr. Kinniry said, “but that’s what a lot of people did.”

Dividing a portfolio between stocks and bonds is a personal decision. If you can afford to ride out a major stock market decline, and truly don’t need to touch your money for a decade or two, you might be fine with a broadly diversified portfolio that holds only stocks, Mr. Kinniry said.

After all, he said, it took only 3 years for such a portfolio to recover all of its losses after the roughly 50 percent stock market decline of the last crash. But withstanding losses like those without selling any holdings took extreme fortitude. That’s why it was easier to live with a broadly diversified portfolio, with 50 percent stocks and 50 percent bonds. Such a portfolio recovered all of its losses in just one year, not three, according to data provided by Mr. Kinniry.

Doing a serious gut check and realistically assessing how you will behave if a major downturn occurs can prevent a lot of pain later. “You don’t want to find out that you don’t have enough car insurance or home insurance until after an accident happens,” Mr. Kinniry said. “You’re better off if you do the inventory now.”

And if the markets do turn out to provide lower returns in the next decade than in the last one, it may be possible to compensate by taking measures that you can at least partly control, perhaps by working more, increasing savings or reducing spending.

The odds have worsened. Surely it’s better to be prepared.

Follow Jeff Sommer on Twitter: @jeffsommer

A version of this article appears in print on , on Page BU4 of the New York edition with the headline: Recession Chances Rise: Time for a Gut Check. Order Reprints | Today’s Paper | Subscribe